Over the past decades, most of the world’s Central Banks have widely used open market operations to influence the short term interest rates and achieve their main objectives of controling inflation and promoting economic growth. Recently, however, the short term interest rates in major developed economies have reached the so-called “zero lower bound” (i.e. they cannot be lowered anymore because with interest rate equal to zero people would simply prefer to keep their money as cash).
Given the grim economic outlook, with unemployment reaching high record levels in US and Euro Countries and a threat of deflation, Central Banks were pushed to use new monetary instruments, the so-called unconventional monetary policies. These policies fall mainly into two categories: (i) Forward Policy Guidance and (ii) Large-scale Asset Purchases (LSAPs), more popularly known as Quantitative Easing (QE).
The Forward Policy Guidance is, in a nutshell, the clear communication by Central Banks of which they expect to be the future path of short-term interest rates. An example of this is the statement released after September’s Federal Open Market Committee (FOMC) meeting in which the FOMC “anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015”.
This type of policy guidance is expected to influence longer-term interest rates and financial market conditions through the expectations channel, more precisely, by affecting the public’s expectations about the future interest rates this can drive down yields of longer-term bonds. Actually, several recent studies point to the success of these statements to influence longer-term yields .
For instance, Swanson and Williams (2012), analyzed the impact of the statement published on August 9th, 2011, in which the Fed announced that the federal funds interest rate were likely to stay at exceptionally low level at least at least through mid-2013. Financial markets interpreted this statement as a sign that the Fed would rise interest rates later than previously expected and, according to the authors, this caused longer-term Treasury yields to fall about 10 to 23 bp at maturities from 2 to 10 years.
The second type of unconventional monetary policy, and perhaps the most discussed one, are the Large-scale asset purchases (LSAPs) or QE, narrowly defined as “the money creation to buy assets”. Similarly to the Forward Policy Guidance, the main objective of these programs is to drive down interest rates and promote economic growth.
There are three main channels through which LSAPs can affect the interest rates: (i) Preferred-Habitat channel, stresses the fact that bonds are not perfect substitutes (bond markets are segmented) and due to this the Fed would be able to affect the interest rates by buying long-term bonds (i.e. the supply of this bonds available to the public shrinks and so the prices increase and yields decrease); (ii) Signalling...